Is the stock market in a Brexit bubble?

Investors should be wary of post-Brexit profits and take a considered approach, warns Guy Stephens, technical investment director at Rowan Dartington.

Elections always serve as a useful reminder of what democracy is supposed to represent. We are all aware that, in this age of populism, a significant proportion of the electorate is disillusioned with the western political system which is encouraging support for more radical ideologies.

Although France has elected a pro-European moderate in Macron, who is market friendly, they have rejected the two mainstream incumbent parties. Imagine the same in the UK. This would be equivalent to the UK electorate rejecting the Conservatives and Labour and a new party of one year’s tenure emerging victorious.

Some may recall the experience of Michael Foot in the 1983 election, the result of which was the Labour Party’s lowest share of the vote. There has been a lot of commentary recently suggesting that the Labour Party could be about to have a similar experience in this election. And when you consider that Jeremy Corbyn has already said he isn’t going anywhere, regardless of the election outcome, this implies that he may be anticipating another leadership challenge very shortly. On the popular assumption that the Conservatives do achieve a majority over 100, there is going to be internal turmoil within the Labour movement, especially if continues to gain support from the unions. We will see.

Election impact on the UK stock market

If we consider the consensus likely outcome for the current UK election, we need to think this through as far as the effect on markets. Both the UK equity market and the UK fixed interest market will be influenced, but more importantly the value of sterling. If Theresa May is returned with a majority over 100, then we will have a Conservative Party which has lurched to the right with a lot of power and a very weak opposition which will be in confusion and disarray. The current thought process is that this will provide a stronger hand when Brexit negotiations start and this should support Sterling and be beneficial in terms of whatever deal is agreed.

As investors we must not forget the artificially positive impact sterling weakness has had on the performance of the FTSE 100 with its proportion of overseas earnings being around 75 per cent. In addition, another performance driver of equity returns in portfolios has been overseas equity exposure where the FTSE World Ex-UK has risen by over 30 per cent in the last year in sterling terms.

So we have a situation where at least half a Medium Balanced portfolio with say 70 per cent equity exposure for a UK investor, has been driven significantly higher by a one-off artificial currency movement, in combination with the Trump reflation trade.

When you consider that sterling is likely to have experienced most of its weakness for the foreseeable future and that most of the Trump reflation positives are priced in for now, the upside for equities from here is looking limited.

Market correction looming?

We have been telling clients that the last year has seen exceptional returns and you should be careful not to forget that going forward, at some point, we will experience a correction and a negative year but currently, we cannot foresee what will bring that about.

It is interesting to note, as we have been advocating, that the FTSE 250 had caught up with the FTSE 100 toward the end of April as value investors found opportunities within Brexit sensitive sectors and as sterling recovered somewhat from its weakest point. However, since the French election, the euro has strengthened against Sterling and Macron’s pro-European stance has been perceived as reinforcing the EU negotiating position with the UK. The FTSE 100 has subsequently moved ahead once more and hit a new all-time high earlier this week.

This means that just as the Brexit vote outcome had a profound effect on the performance of the UK equity market and overseas equity exposure as sterling weakened the future outcome of our Brexit negotiations and the subsequent effect on sterling will also have an abnormal influence on returns.

Stronger pound will reverse translation effect

A contrarian view at the moment would be that Theresa May manages to strike a good deal for the UK, which is both pragmatic and acceptable to Brussels without affecting UK GDP. This currently sounds like a pipe dream but at some point, after a significantly drawn out process, we will strike a deal which will enable businesses and the economy to adjust and adapt. Whether this will translate into positive returns from the equity markets for a UK investor is difficult to determine but logic would suggest that if sterling subsequently recovers, this will be a drag as the translation effect of overseas earnings reverses.

On the basis of this, it would therefore appear sensible to examine the areas of strongest returns, ignore the warm glow of satisfaction that jumps off the page as you look at the profitable positions and condition yourself as if you were holding cash as to what to buy.

In turn, this will prevent behavioural bias from having an unhelpful influence which leads to investors continuing to hold investments because they have been profitable rather than considering taking that profit before it starts disappearing. This is also the essence of value investing and many can remember how careers were made and lost as the technology bubble burst from 2000 to 2003 when the unloved began outperforming.

The real question is whether there is indeed a Brexit Bubble supporting the UK equity market, driven by sterling weakness and apparent UK economic insensitivity. If there is and this starts to deflate for whatever reason we will need to position portfolios accordingly as the future performance drivers shift.

Subscribe to Money Observer magazine

Be the first to receive expert investment news and analysis of shares, funds, regions and strategies we expect to deliver top returns, plus free access to the digital issues on your desktop or via the Money Observer App.